Don't worry about CDS, CLOs or excess leverage - it's a day of celebration

By Welshcake

Friday, March 01, 2019

There are many horrible ways to die. But there are surely few worse things to hear as you go than a Welshman's cackle. On this most celebratory day of the national calendar, our moody columnist is found in morbid reflection...

We’ve been here before. The market has once again reached the phase where news headlines start to mount up claiming all manner of things are about to cause a cataclysm.

But if this all feels a bit like 2006 or 2007, it has little to do with similar structural ailments or an egregious misuse of financial products, and much more to do with the marriage of convenience between hungry bears and eager columnists.

In 2019, the clamour is all about CDS manipulation, a looming triple B apocalypse and explosion of corporate leverage powered by the CLO engine – driving us all to a US subprime-reminiscent collapse. Sounds pretty scary, right?

But let’s step back a bit and remember that hardly any of the dire warnings we read about in 2006/2007 concerned the subprime market. Instead, they always clamoured about other things – like CDS 'counterfeit bonds' and real money fuelling excessive corporate leverage…

It pays to rehash the old hits.

Ask a high yield credit trader in early 2007 about the precipitous drop of the ABX Home Equity index and you would typically draw a response such as, “I don’t know much about that, it’s not my market.” Exasperation was sometimes barely concealed. Not many market participants saw a correlation.

And when, on 14 February, 2007, Creditflux drew people’s attention to the Valentine’s Day Massacre in TABX (the ill-fated launch of ABX HE index tranches), otherwise habitual doom-mongers passed off “isolated squalls” in ABX tranches as something that could be easily absorbed by an overall system awash with liquidity.

This isn’t to blow my own trumpet. It’s just reasonable to imagine headline writers these days are also missing the point, while manufacturing another shoal of red herrings.

Sympathy can be extended to the underlying motivations of columnists and their sources. The last nine years have been a very unhappy time to be a natural bear – and anywhere someone has called a short that person is probably no longer in business. There must be survivors out there just itching to swing the consensus of opinion against the market’s seemingly inexorable rise. Moreover, having a few blowouts to test the system is no bad thing for its overall health.

It’s a simple matter of mud being introduced to a wall.

And imagine the acclaim for journalists when the cycle finally comes to an end and something, anything, goes horribly wrong. The lesson of the financial crisis years is that you don’t actually have to correctly predict this thing itself – you only have to peddle a general sense of gloom for a year or two and make sure everyone remembers you for it.

Right now we’re struggling to put our finger on anything self-evidently akin to the subprime/CDO of ABS dream team. Nor have we spotted many obviously top-of-the-market synthetic products like ‘constant proportion debt obligations’ (remember those beauties?).

That doesn’t mean the causes of the next crisis aren’t hiding in plain sight. The inability of banks to hold much stuff on their books continues to look like a major problem for the buy side when their music stops, but it’s arguably put the banks themselves in a stronger position.

The failure of a major central counterparty would obviously be catastrophic for market stability, but then you would need an epic level of systemic failure to reach that point in the first place.

What seems much more assured, however, is that the press is overblowing those other supposed problems. CDS settlement disputes are excellent fun for those involved, but they don’t undermine the product as a concept. Not many people even care that much about single name CDS particulars – the vast bulk of trading is through index products, after all.

Corporate leverage is clearly important, but it’s hardly something that goes unanalysed. And it’s at a far remove from the catalogue of structural problems and market abuses that created the US subprime crisis. Major corporate borrowers have far better protections than the unfortunate people who took out subprime mortgages, and they offer far better geographic diversification.

Plus they have the CLO engine – and this is a good thing for market stability, not a contributor to disaster. CLOs may contribute to leverage increase by being semi-forced buyers of loans, but they are almost never forced sellers.

And they are nothing like CDOs of ABS, which were effectively CDOs squared with terrible underlying asset quality and mis-sold on a wide scale as highly-rated investments. CLOs neither have (as yet) to contend with a mass-produced synthetic overlay, as occurred in the CDO of ABS market when it had already reached crazy levels of excess.

Speaking of excess, you'd do far better to worry on this day of all days about something more pressing - like where on earth in this city are you going to find your traditional repast comprised of fat, sugar and dried fruit?